As you have no doubt been informed, global stocks are now in a bear market. What happens next?
The most excessive speculation has already been flushed out of the system. Those warning of bubbles in Bitcoin and other cryptocurrencies, meme stocks, or the ARK Innovation ETF’s growth tech companies certainly seem to have been right. Last November, meme stocks were so exciting that they launched their own benchmark measure, the Solactive Roundhill Meme Stock Index. Since then, this index has fallen by 70%. The same is true for ARK and Bitcoin – this looks like a wave of speculative excitement that has flowed into the same things together and has now flowed out again.
Those investments are still important, and it’s possible they will need to fall further. In the case of Bitcoin and the crypto sector, it is also possible that they are large enough to cause losses to create systemic effects as their losses force other assets to be sold. But they are not the focus of the questions we now face.
What we need to know is whether there are more accidents in the future. And that depends in large part on leverage. When unleveraged investments fall, the people who hold them lose some of their wealth. That’s probably having some impact on spending in the economy, but by and large it has been. Relatively wealthy people who hold fixed assets are now relatively less wealthy. End of.
When leveraged investments fall, companies and their lenders can go bust. The need to pay off the debt may result in distress sales elsewhere. So we have our higher interest rates, and the financial system is now projecting significantly higher borrowing costs into the future. This should lower inflation – but the risk is that there are crises for leveraged investments, causing further damage. So, as always, when considering the risk of a financial crisis and wanting to do violence to the French language, the question is: “Cherchez le Leverage”.
If there’s one asset worth scrutinizing, it’s real estate, and credit is its lifeblood. For a double whammy of higher interest rates and the ongoing impact of the pandemic, look to office real estate. Notably, the Bloomberg index of US office real estate investment trusts (REITs) is now slightly lower than it was 20 years ago, almost returning to the lows it hit during the worst of the pandemic in 2020.
This is alarming for anyone who has seen the Manhattan skyline grow in recent years, hardly slowed down by Covid-19. The troubles of Vornado Realty Trust, one of New York’s largest developers, whose share price is 59.5% below its peak five years ago, indicate the magnitude of the problem; The fact that some property developers only just fended off industrial action by the construction workers at the beginning of this year also points to the pressure. There is a lot of capacity that was planned on the assumption that demand for office space would continue at pre-pandemic levels. That no longer looks like a good premise. The drop in REIT prices shows that the price already reflects concerns to some extent, but the impact of a major office developer defaulting on its loans would be painful.
The problem is not limited to the US. European office real estate isn’t as blown and hasn’t suffered as badly since the pandemic, but the FTSE indices for eurozone and UK office REITs, here denominated in euros, show similar problems at work.
Many office property owners, such as endowments and large pension funds, are the very entities that can take a large loss without triggering a systemic cascade. But a rising supply of offices and falling demand in the wake of the pandemic, all being heavily leveraged, is a combination that needs to be closely monitored.
That brings us to dwelling. Interest rates in the mortgage-backed bond market are rising, as might be expected given the move in Treasuries, while the rates actually being offered to US borrowers are even higher. Typical 30-year mortgage rates are now just under 6%, approaching the pre-crisis high of 2006.
This is another market churned up by the pandemic. The demand is shifting. Some locations aren’t as appealing anymore in the WFH era – others are suddenly a lot more exciting. But the key point is that prices have come down. The S&P Case-Shiller index of homes in 20 major cities topped in 2006 and has since lagged inflation — until earlier this year. New York and Miami, both of which were particularly agitated during the housing bubble 16 years ago, have also seen prices rise.
This is uncomfortably reminiscent of the conditions that triggered the global financial crisis. Mortgage lending has not been as easy this time around and the major commercial banks are not as exposed. So the systemic implications are not that profound. But the prospect of incurring leveraged losses on assets people can’t live without is still painful.
Meanwhile, there is also cause for concern in the UK, where housing has traditionally played a more central role in the economy and animal spirits. House prices in London, if not across the country, are higher in real terms than they were at the height of the last boom, according to the Nationwide Building Society’s House Price Index. London housing has benefited from the perception that it offers a haven for wealth from Russia or the Middle East, so downward pressure could be strong from here.
Capital Economics Ltd. also notes that new sales orders to real estate agents are now outstripping new expressions of interest from potential buyers. This has historically been a great leading indicator of falling house prices.
UK housing is less exposed to the interest rate market than it used to be as homebuyers over the past generation have steadily lost their taste for adjustable rate mortgages. But if there’s another hotbed of speculation in the world that could do damage if it bursts, it’s UK property, particularly in London.
In general, as US interest rates rise and the dollar strengthens, it makes sense to expect emerging markets to suffer the most damage over the decades. Compared to previous cycles, they are not in the grip of a major bull market and are therefore less likely to cause systemic problems. But there is cause for concern.
If we look at emerging market government bonds as measured by both Bloomberg and JPMorgan Chase & Co., we see that they have taken a nasty slump. The main indices are no higher now than they were after the 2016 presidential election, when the arrival of Donald Trump briefly rocked emerging markets. This sell-off is now almost the same magnitude as the drop that accompanied the arrival of Covid-19 in March 2020.
Looking at emerging markets outside of China, which now generally need to be treated as law in their own right, the Institute of International Finance notes that flows have turned negative. China, despite all its troubles and all the controversy sparked by its crackdown on the private sector, is still attracting inflows.
However, despite the turnaround in international sentiment, non-Chinese emerging market equities are holding up relatively well. According to the MSCI indices, they have held their value better than the non-US emerging markets included in the EAFE (Europe, Australasia and Far East) index. So far, emerging markets appear to be weathering the storm better than they have in the past.
Can this last? The example of the 2013 taper tantrum, the incident most similar to this year’s sharp rise in US interest rates, points to trouble ahead. Currencies of emerging markets with high budget deficits came under severe pressure. But the IIF says emerging markets could actually benefit this time around from their history of inflation and the fact that international investors still don’t trust them to keep inflation under control. As a result, several major emerging-market central banks began raising interest rates last year at a time when Western peers are now wishing they had hiked as well.
For now, it looks like emerging markets have benefited from investors’ mistrust of them. The same discipline might have helped in the US and western Europe, but their central banks were strong and credible enough to thwart them. To quote the IIF:
Global walking cycles and inflationary shocks are traditionally difficult for emerging markets, but we are not so negative. This is because most of the major emerging markets started raising rates well ahead of the advanced economies, pushing real rates well above G10 levels. In fact, the normalization of longer-term real interest rates is something that is mostly a story for advanced economies, while longer-term real yields – in much of emerging markets – normalized in 2021. Of course there are exceptions. Emerging markets, where inflation is far ahead of monetary policy, have very negative real interest rates. These emerging markets are now facing increasing challenges and are likely to experience further – perhaps significant – devaluation. However, we see such countries as idiosyncratic and not a symbol of a broader EM vulnerability.
As always, there is still plenty of issuance for emerging markets. Part of their health can be attributed to strong commodity prices. If the wandering cycle successfully slows down the economy and lowers commodity prices, that will be difficult. Further dollar strength would put even more pressure on their debt. And intense activity in shorting the Japanese yen is likely to provide artificial support for some of the more popular emerging currencies, such as the Brazilian real. They would be vulnerable if the yen appreciated sharply.
But as of this writing, it looks like emerging markets remain in reasonable shape to deal with the upcoming financial tremors. Unfortunately, the same cannot be said of global real estate.